All The Devils Are Here: Unmasking the Men Who Bankrupted the World (34 page)

By all appearances, the Fannie Mae that Raines inherited was a well-oiled machine. It utterly dominated the traditional mortgage market, guaranteeing almost three-quarters of a trillion dollars worth of securitized mortgages, many of them thirty-year fixed-rate loans. It was so powerful that it essentially dictated the terms under which prime borrowers could get such loans. Its other, far more profitable business—buying up mortgages and mortgage-backed securities to keep on its own books—was growing by leaps and bounds. It held, by then, more than half a trillion dollars worth of mortgage assets on its books. Fannie was just beginning to tiptoe into riskier mortgages, but it was doing so cautiously; it didn’t care for credit risk. To the extent that subprime mortgages could help the company meet its affordable housing goals, Fannie had better ways to reach those goals—ways that wouldn’t dent its profits.

By the end of the 1990s, Fannie and Freddie’s combined assets exceeded the GDP of any nation except the United States, Japan, and Germany, according to a research report by Sanford Bernstein. There was even talk—encouraged by the GSEs—that Fannie and Freddie’s thirty-year note was going to replace thirty-year U.S. Treasury debt as the United States’ benchmark bond.

Then there was the GSEs’ regulator, the Office of Federal Housing Enterprise Oversight. It was a nonfactor—woefully understaffed, dependent on Fannie and Freddie for information, and regularly trounced by Fannie’s congressional allies on the rare occasions it tried to assert itself. Fannie’s capital requirements were minimal. Its leverage was sky high—over 60 to 1. Its earnings were growing steadily, while its stock rose tenfold during the decade. Fannie’s executives, their compensation tied to the company’s earnings goals, got very rich. It still had critics, of course, but it had proven time and again that it could swat them away like an irritating fly.

Which perhaps explains why, not long after becoming CEO in 1998, Raines met with some of the company’s investors and laid out an extraordinary
target. He felt confident, he said, that the company could double its earnings per share over the next five years, from $3.23 to $6.46. That number became a kind of mantra within Fannie Mae; even its chief internal auditor—who is supposed to be immune to earnings concerns—once told his troops, “By now, every one of you must have 6.46 branded in your brains. You must be able to say it in your sleep, you must be able to recite it forwards and backwards, you must have a raging fire in your belly that burns away all doubts, you must live, breathe, and dream 6.46…. After all, thanks to Frank, we all have a lot of money riding on it.”

In retrospect, it is hard to see this target as anything but hubris. For all their power, the GSEs’ business model was seriously constrained. Being a government-sponsored enterprise had a few minuses as well as pluses. One of the major drawbacks was that Fannie and Freddie’s charters prevented them from diversifying into other businesses. The only business they could be in was the one they already dominated: the secondary market for home mortgages. And with the rate of homeownership approaching 68 percent by 2002 (an all-time high), how much could that market really grow? A former Fannie executive recalls that after Raines announced his new target, “All the vice presidents in the company looked at each other and said, ‘How is this going to work?’ ”

In truth, the only way Fannie Mae could continue its rapid growth was to keep expanding its controversial mortgage portfolio. As you’ll recall, there was no particularly good “housing” reason for Fannie Mae to have such a gargantuan portfolio, especially in good times, when there were plenty of buyers of mortgages and mortgage-backed securities. (In bad times, an argument could be made that it was important for Fannie and Freddie to buy up mortgages to keep the mortgage market going. Since the financial crisis, in fact, that is precisely what the GSEs have been doing.) Fannie’s critics were mainly worried about the interest rate risk in the portfolio—and the more the portfolio grew, the more the fears grew as well. To hedge that risk, Fannie and Freddie were huge buyers of derivatives, quite likely the biggest in the country. But hedges don’t always work, and critics feared that if there was an abrupt shift in interest rates and Fannie began taking big losses, the taxpayers would be the ones picking up the tab. After all, Fannie had come close to the brink many years earlier, before David Maxwell saved the company.

If there was one thing Raines had inherited from Jim Johnson, it was a pugnacious attitude toward anyone who dared criticize Fannie Mae; indeed, it sometimes seemed as if he were trying to outdo his predecessor. “I think
Frank’s fear was that he couldn’t be tough enough, and he overcompensated,” says a former Fannie executive. For his part, Raines would later say, “We never had any illusion at Fannie that we were all-powerful. If we were all-powerful, we wouldn’t have had to fight so many battles. All day every day, we felt besieged.” As Fannie Mae really did become besieged, so did the ferocity of Fannie’s response—to the company’s, and the country’s, ultimate detriment.

The first real shot across Fannie’s bow during the Raines era came even before the Bush administration took office. Toward the tail end of Clinton’s second term, Richard Baker, a Republican congressman from Louisiana and a longtime critic of the GSEs, introduced a GSE reform bill.
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Larry Summers, who was by then the Treasury secretary, decided to come out in favor of the reforms. There was no way Baker’s bill was going to pass; the combination of a lame-duck Democratic administration, a Republican-controlled Congress, and Fannie and Freddie’s political power made that obvious. But Summers wanted to sound the alarm about the portfolio risks. He got the White House to agree, telling Clinton’s chief of staff, John Podesta, that although Treasury would testify for the bill, it wouldn’t invest any political capital. Maybe, Summers thought, the next administration would pick up the cudgel.

It was strange, in a way. Within the administration, Summers invariably took the Greenspan position that the market was better equipped to recognize and handle risk than Washington regulators. And, like Greenspan, Summers’s belief that the market cured all problems blinded him to the systemic risks that were building up.

But he could see all too clearly the risks posed by Fannie and Freddie. For officials like Greenspan and Summers, there was something offensive about the GSEs. The moral hazard that existed in the banking system—and that would be all too obvious during the financial crisis—was something policy makers couldn’t see. But the moral hazard posed by Fannie and Freddie?
That
they could see plain as day.

In late 1999, Summers made a speech at a Women in Housing & Finance conference, which included one sentence about Fannie and Freddie: “Debates about systemic risk should also now include government-sponsored
enterprises, which are large and growing rapidly.” That one line got Fannie’s attention; Summers got his first taste of Fannie’s legendary pushback. Fannie’s vice chairwoman, Jamie Gorelick, called Treasury to complain about the “attack.” Raines called Summers personally. Both expressed outrage.

A few months later, it was Take Your Daughters to Work Day. Summers brought his two daughters, as one former Treasury executive recalls. Another employee said to them, in an obvious reference to the GSEs, “What would you tell your daddy to do if there are people who are doing a lot of harm, and Daddy could take them on, but they might do Daddy some harm, and nothing he does may do any good?”

“Oh, is Daddy like Rosa Parks?” asked one of Summers’s daughters.

Finally, on March 22, 2000, assistant Treasury secretary Gary Gensler testified in favor of Baker’s bill on behalf of the administration. Among other things, he said that the U.S. Treasury should consider cutting off the GSEs’ $2.5 billion lines of credit with the federal government.

All hell broke loose. At the hearing, Gensler was berated by Fannie’s many defenders. Yields on GSE debt rose dramatically, meaning that investors suddenly viewed Fannie and Freddie as riskier bets. This, in turn, reduced the spread Fannie could earn on its portfolio, which threatened Fannie’s earnings. Fannie reacted even more intemperately than usual, calling Gensler “irresponsible,” “unprofessional,” and (of course) antihousing.

Congress quickly rose to Fannie’s defense. Within a week, Rick Lazio, the Republican chairman of a key housing subcommittee, announced that he would oppose any legislation that would, as he put it, increase costs to home buyers. Senate Minority Leader Tom Daschle, a Democrat from South Dakota, went on C-SPAN to say that Fannie had done a “phenomenal job” over the years, and “if it ain’t broke, don’t fix it.”

That wasn’t quite the end of the story. Behind the scenes, for a period of about a year, the Treasury Department also held a series of unpublicized meetings with Fannie’s top executives. The meetings were conducted at Fannie Mae’s instigation. In an effort to appease its critics, Fannie Mae had put together a series of “voluntary” initiatives that it hoped to get Treasury to sign off on, which included such measures as disclosing more information about its interest rate risk. It was classic Fannie Mae: keep your friends close and your enemies closer. But the chemistry between Summers and Raines was “horrible,” in the words of one former executive. “The two of them were so alike,” this person explains. “They were both arrogant, stubborn sons of bitches, and they both viewed themselves as the smartest guy in the room.”
Summers simply didn’t believe the Fannie team when they explained why it was necessary for Fannie to own that huge portfolio of mortgages. And he absolutely scoffed when Fannie insisted that it received no subsidy and posed no risk to taxpayers. “They made the mistake of insulting his intelligence,” says a former Treasury official.

The initiatives turned into a small comedy of errors. Freddie Mac, having gotten wind of Fannie’s plans, did an end-around, working out a deal to announce the initiatives with Richard Baker. The weekend before the announcement, however, Fannie Mae discovered that Freddie was going to one-up it. So it joined in and took part in the announcement. But the point of the exercise had always been to get Treasury to sign off on the initiatives, which would have signaled to the marketplace that Treasury was finally aligned with Fannie’s business model. That never happened. And without the Treasury on board, the initiatives did little to quell the criticism.

It was pure political calculus that initially caused the Bush administration to decide to leave Fannie and Freddie alone. It’s not that the White House didn’t understand the issue, or that there weren’t a smattering of critics inside the administration. But Fannie also had its internal defenders: the head of the National Economic Council was Steve Friedman, the former Goldman Sachs senior partner who had run the firm with Bob Rubin. He had been on Fannie’s board of directors. Besides, Fannie and Freddie could be useful props to help support Bush’s homeownership bona fides.

Yet one of the leading Fannie haters in the Bush administration wasn’t some anonymous White House economist; he was the head of OFHEO. His name was Armando Falcon Jr. and he was Fannie and Freddie’s regulator.

Like Raines, Falcon was a product of the meritocracy. The son of an aircraft technician from San Antonio, Texas, Falcon had gone to the University of Texas law school, and then Harvard’s Kennedy School of Government, before landing a job in 1990 as general counsel of the House banking committee. After losing a race for Congress, Falcon was nominated to head OFHEO. He was in his early forties when he ran the agency, a seemingly shy, hesitant man who liked poker and cigars. He lacked the charisma and brilliance of someone like Frank Raines. He was easy to underestimate. As he came to understand just how difficult the GSEs were to deal with—and how powerless OFHEO was to do anything about them—he first became frustrated and then deeply angry.

Every year, it seemed, OFHEO’s proposed budget was cut, either by
Congress or the White House. When Falcon first took office, he later recalled, he discovered that some risk examinations were being put off because the agency didn’t have the manpower to conduct them. The agency estimated that it needed sixty examiners to do its job properly; it had seventeen. OFHEO’s entire budget, which ranged between $19 million and $30 million, was less than the total compensation of the four top executives at Fannie and Freddie.

In 2000, the year after he took the job, “Representative Maurice Hinchey bravely offered an amendment on the floor of the House to increase OFHEO’s budget,” Falcon would later testify. “The amendment was angrily opposed by the chairman of the VA, HUD appropriations subcommittee, who lashed out at me personally for encouraging the amendment.” It didn’t pass.

Given its live-and-let-live attitude toward the GSEs, the Bush White House was not an early supporter of OFHEO. Nevertheless, in 2002, Falcon decided to initiate a study on the systemic risks posed by the GSEs. It would be hard to imagine a more important topic for OFHEO to tackle. It would also be hard to imagine a topic more likely to inflame Fannie Mae.

By early 2003, OFHEO was set to release its report. In truth, it wasn’t all that tough. “The possibility of either Enterprise failing or contributing to a financial crisis [is] remote,” it concluded. But it also raised the possibility—small though it was—that Fannie or Freddie could get into trouble and “cause disruptions to the housing market and the financial system.”

Most companies would have accepted such mild criticism with, at most, a press release rebuttal. But, according to Falcon, Raines and Fannie Mae immediately went into overkill mode. A few days before the report was set to be issued, Raines called Falcon and asked him not to issue it. “When I reaffirmed my plans,” Falcon later said, “he threatened to bring down me and the agency.” Fannie lobbyists then called Treasury and other regulatory agencies, asking them to press OFHEO not to release the report. (Raines calls Falcon’s allegations “totally made up.” Although he called Falcon to tell him that “it was highly unusual for a regulator to issue a report saying its regulated companies might bring down the financial system,” he insists there was no threat.)